DBRS Confirms Canfor Ratings, Changes Trend to Stable

DBRS has today confirmed the Issuer Rating and Senior Notes rating of Canfor Corporation (Canfor or the Company) at BB (high). The trend has been changed to Stable from Negative. This rating action recognizes the Company’s much-improved financial results in 2010, which were well above expectations, demonstrating Canfor’s ability to benefit from positive market developments to strengthen its financial profile.

Prior to 2010, operating performance at Canfor had been weak, affected by a prolonged, severe downturn in the U.S. housing sector, and the Company had reported losses in the previous four years. The U.S. housing market bottomed in 2009 but the pace of recovery through 2010 has been disappointing. However, both lumber and pulp prices strengthened in 2010, helped by some unexpected developments. A temporary demand/supply imbalance in lumber led to a sharp increase in prices in early 2010. Prices retreated sharply in mid-year as the imbalance dissipated. However, producer discipline in managing supply and much stronger-than-expected demand from China reversed the decline, resulting in a substantial year-over-year increase in 2010 average lumber prices. A similar supply/demand imbalance also helped raise pulp prices. Demand for pulp has been growing in emerging markets, especially China, as their economies strengthened. A supply disruption caused by the earthquake in Chile in February 2010 worsened already-tight inventory conditions in the global pulp market. Pulp prices rose sharply, peaking in Q3 2010, and remained at elevated levels despite a moderate retrenchment.

Canfor reported much stronger results in 2010, helped by sharply higher product prices, especially for lumber, as well as by benefits from cost savings initiatives which were partly offset by a strong Canadian dollar.

In the near term, the lumber business is expected to report modest profit improvement. Canfor has made good progress in developing the Chinese market, where sales are expected to continue to rise due to an ongoing increase in consumption and restricted supply from Russia. In addition, the growing use of high-grade lumber in China will lead to a better sales mix. However, the health of the U.S. market remains the key to Canfor’s overall performance; the United States still accounts for 54% of Canfor’s 2010 sales, compared with China’s 17%. DBRS believes that the U.S. housing market has passed its trough but there are still headwinds facing the industry: (1) The boost from the homebuyer tax credit in the United States expired at the end of April 2010. The lack of stimulus and the negative impact of pulled-forward sales could dampen demand for the rest of 2010 and into 2011. (2) The persistent high unemployment rate in the United States and its resultant impact on the confidence of potential homebuyers could continue to pressure demand and further delay any meaningful recovery in the housing market, despite favourable mortgage rates. (3) Credit availability remains tight and weighs on builders’ ability to start new projects. Consequently, DBRS believes that residential construction and the resultant demand for lumber is not likely to show a meaningful improvement until late 2012.

The near-term outlook for pulp is stable but has a downward bias. Global pulp inventory levels are lean and demand/supply appears to be in balance. However, an increase in supply from Chile (from the restoration of production post-earthquake) and the start-up of new mills at Latin America would tip the balance. Hardwood pulp prices have been under pressure. In addition, there are signs that the momentum of economic recovery in some major economies is stalling. Lingering concerns about the European sovereign debt situation and recent political turmoil in the Arab countries further add to the uncertainty. A slowdown in global economic activities would dampen demand and put pressure on pulp prices. Moreover, the industry still has excess capacity, which is temporarily idled and can be easily restarted when prices become more favourable. This capacity overhang would also limit the upside in pulp prices.

Overall, DBRS believes that Canfor should continue to show modest improvement in its operating performance until the U.S. housing market shows meaningful growth.

The Company’s strong balance sheet provides good support to the current rating. Canfor has continued to pay down debt and its gross leverage was a modest 18% (21.4% adjusted for operating leases) at the end of 2010. With a liquidity position of about $643 million (cash and unused credit facility) at December 31, 2010, the Company has adequate liquidity to weather an extend period of weak market conditions. DBRS expects the Company’s financial risk profile to show modest improvement and the rating to remain stable in the near term.

DBRS has simulated a default scenario for Canfor in order to analyze the potential recovery of the Company’s senior debt in the event of default. The scenario assumes a prolonged period of severe economic conditions regardless of how hypothetical or unlikely the conditions may be, in which product demand and prices plummet. Based on the recovery analysis, DBRS believes that the senior note holders would recover approximately 50% to 70% of the principal; DBRS has therefore assigned a recovery rating of RR3, an improvement from the prior recovery rating of RR4.

Notes:
All figures are in Canadian dollars unless otherwise noted.

This rating did not include issuer participation and is based solely on publicly available information.

The applicable methodologies are Rating the Forest Products Industry and DBRS Rating Methodology for Leveraged Finance, which can be found on our website under Methodologies.